A Real Estate Jockey Play That I'm Buying

I've been a bargain shopper my entire life. When I was a kid with limited funds, I did all of my back-to-school shopping on the clearance rack, and I wasn't afraid to wear shoes that were a size too big if I could get a great deal. During those formative years, two of the most important lessons that I learned is that most things are cheap for a reason, and that it's truly rare to find a bargain if you look where everyone else is shopping.

At a time when investors are piling into real estate investment trusts because of their relatively high dividend yields, it's hard to find many real estate stocks that I consider a bargain. So instead of competing with the herd, I diverged. I found a real estate company that pays no dividend, has limited operating history, and has yet to turn a profit -- not exactly what most real estate investors are looking for these days. However, this company has an amazing portfolio of prime real estate, and an all-star management team that should produce healthy returns for long-term investors who can buy and wait.

The businessLess than a year ago, Howard Hughes (NYSE: HHC) was spun out of General Growth Properties (NYSE: GGP) during the retail REIT's bankruptcy reorganization. Howard Hughes was created specifically to hold a disparate portfolio of real estate assets that would require a significant investment of time and money to realize their full value. Fortunately, when Howard Hughes was spun out, it was set up to succeed, thanks to a solid balance sheet that holds relatively little debt for a real estate company.

This shouldn't be a surprise, since Bill Ackman, the CEO of the company's largest financial stakeholder, Pershing Square Capital Management, played a significant role in organizing the new company as a member of General Growth Properties' board of directors. Ackman is a well-known hedge fund manager who has recently been involved in activist positions in J.C. Penney (NYSE: JCP) , Fortune Brands (NYSE: FO) , and Family Dollar (NYSE: FDO) , and he now claims the position of chairman of Howard Hughes' board. From that position, Ackman has been instrumental in handpicking management for the company, selecting seasoned developer David Weinreb as CEO, and designing an incentive program that aligned management's interests with that of shareholders (more on that below).

The assetsThough the properties in Howard Hughes' portfolio were undesirable to General Growth Properties, they would be considered prime assets by most real estate investors. That explains the laundry list of upper echelon investment houses, including Pershing Square, Brookfield Asset Management, Fairholme, and Paulson and Co., that have accumulated heavy equity and/or warrant positions in Howard Hughes. Examples of Howard Hughes' assets include:

Three master planned communities comprising more than 14,000 acres of unsold residential, retail, and commercial property in Nevada, Texas, and Virginia;

2.6 million square feet of retail and commercial space, including 60 acres of beachfront property in Honolulu zoned for 9.3 million square feet of mixed-use development;

17 strategic development assets that vary from raw land to 80% of the air rights above Fashion Show on the Las Vegas strip.

The art of the dealWhile Howard Hughes' portfolio is extremely diverse, the one thing that these properties have in common is that they're extremely hard to value without a look at the company's books and detailed knowledge of local real estate markets. Howard Hughes stock is trading hands for just 83% of the company's book value. This suggests that the market is skeptical about the company's ability to add value by redeveloping its properties and improve management of the operating assets. However, I believe that the market is mistaken for a few reasons.

First, many of Howard Hughes' properties are recorded on the books for well below their obvious market value, providing a margin of safety to that 85% mentioned above. For example, Howard Hughes owns the historic South Street Seaport in New York City, which it carries on its books at $3.1 million. But the property generated more than $5 million in net operating income in 2010. If you assume a 6% cap rate (the ratio of net operating income to property value), which is fairly conservative for the Manhattan real estate market, the property is worth more than $80 million. If the property were redeveloped, it could be worth multiples of that amount. Additionally, Howard Hughes owns 20 acres of ranch land in Maui and holds 80% of the air rights over the Fashion Show on the Las Vegas strip -- and carries them both on the books at a value of $0!

Also, the company performed an extensive review of its properties just last year and took more than $500 million in impairment charges across many properties. Management had every incentive to be as conservative as possible when it wrote down the book value of these assets. By marking down the book value last year, Howard Hughes took the losses before the company was closely followed by analysts and reduced the likelihood of future markdowns that could hurt the stock. Additionally, the markdowns created net operating losses that can be used to reduce income taxes in future years and buoy earnings.

Finally, when Howard Hughes' CEO, David Weinreb, and president, Grant Herlitz, were hired, they had the opportunity to take a close look at the portfolio before deciding that it was prescient to invest $15 million and $2 million, respectively, of their own cash in warrants with a $48.56 breakeven, that wouldn't vest for six years. Then when CFO Andy Richardson joined the company three months later, he picked up $2 million in warrants with a breakeven of $65.58 and the same lock-up period. This leads me to believe that this team of experienced real estate developers liked what they saw and believe that these assets have the potential to be worth a lot more than the $47 a share that the the stock is trading at today.

What I'm watchingWith a softening economy and concerns about a potential credit crisis in Europe, there's a good chance that it will be more difficult to raise capital over the next several months. Ackman has stated explicitly that the company plans to find joint venture partners to fund their projects rather than add a lot of leverage to the balance sheet. Howard Hughes' recent announcement of a partnership with two Hawaiian development groups to begin work on its Ala Moana property in Honolulu is a perfect example of management's strategy. With a group of elite investors as major shareholders, I'm sure Howard Hughes' management has access to a large Rolodex of potential partners with deep pockets.

The Foolish bottom lineWhen I came across a company that owned a portfolio of trophy properties, with world-class management, selling at a significant discount to its book value, I felt like a little kid who just found a pair of Air Jordans in the bargain bin. Howard Hughes' management team is highly incentivized and with Ackman leading the board, we can be confident that they will be motivated to create shareholder value. Though I'm not expecting huge gains in the near term, I think this is a great investment for someone with a five- to 10-year time frame and the patience to let management do their job. A day after this article is published, I will be adding $1,000 worth of shares to the Total Realty Portfolio.

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